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Economic Modelling

Lecture 19

Policy Game in the Global Economy

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Source: Phillip’s Atlas of the World

Growing Together or Growing Apart?

East and West?

North and South?

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Two Economy Inter-dependent Global Economy Model

111111 MXGICY

211 YkX 111 YmM

Economy 1

Economy 2

222222 MXGICY

122 YkX 222 YmM

2121

2221

2121

21111 1111

1

kkmm

GICk

kkmm

mGICY

What is Y2 ?

4

5,56,3

3,64,4

...............................

C

NC

CNC

CountriesDeveloping

CountriesAdvanced

5,56,3

3,64,4

...............................

C

NC

CNC

CountriesDeveloping

CountriesAdvanced

Cooperation or non-Cooperation?

Nash Solution is non-cooperation (NC,NC) =(4,4)

Cooperative Solution (C,C) =(5,5)

Cooperative solution Pareto dominated Non-cooperative solution.

Pareto efficiency: at least one party gains without hurting the other.

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Developing

Economies

Advanced economies

Extensive Form of International Cooperation Game

NC

C

NC

C

NC

C

(4,4)

(6,3)

(3,6)

(5,5)

Advanced economies

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Developing

Economies

Advanced economies

Dynamics of International Policy Cooperation Game: Solution by Backward Induction

NC

C

NC

C

NC

C

(4,4)

(6,3)

(3,6)

(5,5)

Advanced economies

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Both gain by playing (C,C)

But this solution is not credible.There is incentive to deviate. Trigger Strategy

Game returns to Nash path in absence of credibility.

If the game is played infinite number of times the optimal discount valueff the game is calculated as

1

55...5555),( 32 nCCPV

1

55...5555),( 32 n

nLimCCPV

ncheatPV 4...4446)( 32

Credibility Problem, Cheating and Discount Factor of the Game

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1

55...5555),( 32 n

nLimCCPV

ncheatPV 4...4446)( 32

132 4...446)( ncheatPV

466)(1 cheatPV 0lim

1

n

n

1

46)(cheatPV

146

1

5

4165 256 2

1

Solution for the Discount Factor of the Game

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Yn

UnemploymentDeflation

Inflation Boom

i=i*

S

K Inflow K Inflow

X-M=0K outflow K outflow

Internal and External Stability in an Open Economy

output

0

10

Yf

i=i*

IS LM

S

BOP+K-inflowDeflation

i>i*

i<i*

BOP+ K inflowBoom

BOP: X-M =-KA

BOP-K-outflowDeflation

Under full employment.

BOP- OutflowBoom/inflation

Over full employment

Macroeconomic Equilibrium in a Small Open Economy with Perfect Capital Mobility

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Yf

i=i*

IS LM

S

BOP+EXDGEXSM

i>i*

i<i*

BOP+EXSGEXDM

BOP: X-M =-KA

BOP-

EXDGESM

BOP-EXSGEXDM

A Small Open Economy with Perfect Capital Mobility: Convergence towards A Macroeconomic Equilibrium

Notes: YF full employment output, BOP = Balance of Payment, K= capital, ESG =Excess supply of goods, EDG =Excess demand for goods, ESM =excess supply of money, EDM=excess demand for money

EXSGEXDM

EXDGEXDM

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Country 1 adopts expansionary fiscal policy output and interest rates, imports and reserves of foreign currency rise in country 1. Country 2 can export more to country 1 but looses some foreign

assets, money supply decreases, and demand decreases and may have contractionary impact if its increase in exports are less than it lose of reserves.

1

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4

5 6

Interdependent Global Economy: IS-LM-BP Model

1i i

y2y1

IS1 IS1’ LM1

LM1’LM2

IS2

LM2’

IS2’

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Policy Spill-over Effects in Interdependent Economies

Answer: Use a two country Mundell-Fleming Model

In fixed exchange rate with perfect capital mobility: 0g

Y ; 0*

g

Y ; 0g

R ; 0*

g

R

Expansionary fiscal policy in country 1 Impact in country 2

i2=i2*

i1=i1* BOP

LM2’ LM1 LM2 LM2 IS2 IS2’ IS1’ IS1 O y0 y1 y2 o y0 y2 y1

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International Economic Policy Co-ordination

• Gold-Standard: Automatic Adjustment Mechanism• Bretton Woods-Dollar standards• Break down of the Bretton Woods: Exchange rate crises • Plaza and Lauvre Accords and G7 Meetings• EU Growth and Stability Pact• Basel agreement of central banks, EMU, AMU,

ECOWAS • IMF/ WB: Seal of approval - Paris Club• GATT-WTO-NAFTA-APEC-ASEAN-GCC

• What are right models for Co-operation or negotiations?

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TYC 8.010 ; 10I ; 10G ; 10T ;

YM 3.0 ; *3.0 YX

YYGITYMXGICY 3.03.08.010 *

*3.0108.0105.0 YGIYY =>

*6.044 YY

Multipliers:

Open Economy: 23.08.01

1

Closed economy: 58.01

1

Interdependent Economy: 125.33.06.03.08.01

1

*6.044 YY ; => 446.0 * YY => 1104.0

44Y

Interdependent Global Economy: An Example Blanchard (19.5)

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Suppose target income at home is Y =125.

Foreign income then 1191256.044* Y The government expenditure to achieve target income given this foreign income

*3.0108.0105.0 YGIYY => *6.0224 YGY ; 1196.0224 GY =>

G= 14.8 Net export at home 8.11253.01193.0 NX ; Government budget deficit at home:

8.48.1410 GT Budget deficit abroad 0** GT ; and Foreign country’s net export:

8.11253.01193.0 NX =>foreign country benefits by doing nothing.

Policy Spill-over Effect -1

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If both countries like to achieve 125 level of target output; the common increase in G necessary to achieve this target output can be found as:

125* YY ;

1256.0224 GY =>

2624751252 G =>

13G 0* NXNX ; 3** GTGT

Policy Spill-over Effect

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Country A Country B 5.05.0

AAA LKY

1.0A

2.0As What is the capital stock in the steady state in A in Autarky? How much do workers get? How much do owners of capital get?

AAAA KLsK 5.05.0

AA KK 1.0102.0 5.0

400AK

200AY

5.05.0BBB LKY

1.0B

0Bs What is the capital stock in the steady state in B in Autarky? How much do workers get? How much do owners of capital get?

BB KK 1.0100.0 5.0

0BK 0BY Becomes a beggar country.

Autarky: Saving, Capital Accumulation and Growth (Gartner (2003:262) has similar example)

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Country A Country B

KKK BA Country A saves for both countries. It receives rental income from country B.

KKKK 1.0105.0102.0 5.05.0

22515 2 K 15010225 5.05.05.0 AA LKY

GNP in country B = GDP+Investment Receipts GNPA = 150+75 = 225 Capitalists gain and workers lose in country A.

KKK BA Country B does not save but can borrow capital from country A.

15010225 5.05.05.0 BB LKY Country B need to pay capital income to Country A. GNP in country B = GDP- Investment Payments GNPB = 150-75 = 75 Country B gains from the capital transfers.

Impacts of Globalisation in Output and Income

What is the capital stock in the steady state in A and Bif there is a free mobility of capital?

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R*: foreign reaction

R: domestic reaction

450

B

B*

C

Gro

wth

rat

e of

mon

ey s

uppl

y in

for

eign

cou

ntry

Growth rate of money supply in home country

N

gmN

gmN*

International Monetary Policy Co-ordination GAME :Hammada Diagram(Romp p.175)

IC

IC*

B: Domestic blissB*: Foreign blissC: Pareto optimalN: Nash Equilibrium

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t*

t

R*

R

Optimal Tariff Game: Johnson (1954)

A

A*

I1

I2I3

I1*I2*

I3*

N

Nash equilibrium is not Pareto Optimal as the indifference curves cross each other but are not tangential.

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t*

t

R*

R

Optimal Tariff Game: Johnson (1954)

A

A*

I1

I2I3

I1*I2*

I3*

N

Nash equilibrium is not Pareto Optimal as the indifference curves cross each other but are not tangential.

E

E

EE line shows all Pareto Efficient points

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ReferencesBlanchard (2003) Macroeconomics, Prentice Hall.Bhattarai (2001) Welfare Gains to UK from a Global Free Trade, the European Research Studies, Vol. IV, Issue 3-4,

2001. • Binmore Ken (1999) Applying Game Theory of Automated Negotiation, Netnomics,1999, v.1, iss.1 pp.1-9.• Canzoneri M. B. and J A Gray (1985) “Monetary Policy Games and the Consequences of Non-

Cooperative Behaviour”, International Economic Review, 26:3:1985, pp. 547-567.• Benigno, Pierpaolo (2002) A Simple Approach to International Monetary Policy Coordination; Journal of

International Economics, June 2002, v. 57, iss. 1, pp. 177-96• Johnson H. G.(1953-54) Optimal tariffs and Retaliation, Review of Economic Studies, 21(2),

pp.142-43.• Harrison, G.W., T.F.Rutherford and D.G. Tarr (1997) “Quantifying the Uruaguy Round”, Economic Journal vol.

107 no. 444, September, pp.1405-1430,• Binmore Ken (1999) Applying Game Theory of Automated Negotiation, Netnomics,1999, v.1,

iss.1 pp.1-9.• Hamada K (1976) Strategic Analysis of Monetary Interdependence, Journal of Political Economy,

84 August.• Ranis Gustav and L. Raut (1999) ed. Trade Growth and Development, North Holland.• Shoven, J. B. and J.Whalley (1984) “Applied General-Equilibrium Models of Taxation and

International Trade: An Introduction and Survey”, Journal of Economic Literature, vol. XXII, Sept,1984, pp.1007-1051.

• Whalley John (1985) Trade Liberalisation Among Major Trading Areas, The MIT Press.• Williamson J. and M. Miller (1987) Targets and indicators: a blue print for international co-

ordination of economic policies, Institute of International Economics, Washington.

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Should Policy be Active or Passive? Classical Economists on Economic Policy

Economy left itself will do better than with an active intervention.

Perfectly flexible prices of goods, labour and capital guarantee full employment equilibrium consistent with maximisation of welfare.

Supply creates its own demand in a free market economy (general equilibrium model as we discussed in micro foundation part describe the frictionless economy).

Classical economists believed that active policy may do more harm than good.

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Lags in Economic Policy

Recognition lag: turning points of business cycle difficult to recognise Decision lag: parliamentary process, dispute among political parties Implementation lag: It takes time for policy to reach to grass-root level Impact lag: institutional and technological inertial and persistent habits

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Classical economists suggest “do-nothing” or “do minimum” policy to be better than an active policy. - Well-intentioned policy makers do more

harm than good. - The self interest of the policy makers

may not be in the best interest of the country.

- Money is neutral. Monetarist argue for a money supply rule such as the interest rate rule Keynesian favour active policy New-classical like classical argue for

minimum role of the government

Classical, Keynesian and Monetarist Approaches to Economic Policy